Australia's banking system has been given a stable outlook by Moody's but the rating agency has warned of possible contagion from the eurozone crisis.

Both the domestic economy and banks' fundamentals are strong, according to Moody's, which rates 15 Australian banks.

The Australian banking system is rated one of the highest in the world, with a weighted average rating of Aa2, according to Moody's.

However, the agency warned that over the next 12 to 18 months banks could see their funding costs increased, as well as a reduced foreign appetite for Australian bank debt and slow economic growth, depending on how "severe and protracted any contagion from the European sovereign crisis may be".

Patrick Winsbury, a senior vice president at Moody's, said: "Australia's banks have built sizeable capital buffers to absorb possible weakness in asset quality, and they have a good measure of flexibility to deal with the challenging conditions in the international wholesale funding markets."

He said banks' earnings are set to remain resilient with solid levels of capitalisation which will help them to "absorb a broad range of downside scenarios".

"We also note the favourable nature of the deposit environment and a creditor-friendly regulatory environment," said Winsbury.

The strong economy will continue into 2012, according to him.

"This dynamic will support the banks' earnings and asset quality, although we anticipate pockets of deterioration in some business lines," he added.

Moody's says that although the Australian banking system is dependent on external wholesale funding which "increases sensitivity to exogenous shocks", major banks are reducing this reliance as deleveraging continues.

"In this context, the Reserve Bank of Australia's Committed Liquidity Facility is a solution to the structural inability of Australian banks to meet the Liquidity Coverage Ratio requirement," it added, but said the Australian Prudential Regulation Authority still expects banks to minimise reliance on the RBA facility by restructuring their balance sheets.

"[The banks] have solid common equity bases that will allow them to transition early to the regulator's tougher-than-standard Basel III capital requirements," the agency said.

Australia was handed a coveted AAA rating on Monday by Fitch ratings agency on the back of its strong performance amid the current global economic turmoil.

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